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Archive for the ‘FT Columns’ Category

The many insights of prospect theory

My latest column in the Financial Times looks at some of the helpful ways that prospect theory illuminates how asset prices are set and fund managers are rewarded.  Prospect theory originally developed from studies carried out by psychologist Daniel Kahneman and his colleague Amos Tversky. Prof Kahneman’s must read book Thinking Fast, Thinking Slow continues to ride high in the bestseller lists. To read the column on the FT website follow this link.

Written by Jonathan Davis

July 2, 2014 at 12:41 PM

Views on Europe

Back from a two-day trip to Paris, it is no surprise to find that the markets are still obsessing about Europe. In the absence of elections political change is rarely a straightforward business, as this week’s tortuous attempts to form new governments in Italy and Greece are demonstrating. The markets remain volatile, but as yet nothing has happened to change my view that we are moving towards an endgame that will ultimately prove beneficial, howver messy it becomes in the short term.

What is noticeable is how opinion is at last slowly shifting away from arguing over how the eurozone in its present form can be saved towards the (more sensible) view that the eurozone cannot continue exactly as it is, whether or not it survives the immediate crisis.. See for example an excellent piece by Lord Owen, the former Foreign Secretary, writing in The Guardian on Monday which begins:

A eurozone may survive, but it will not be the present 17 member state eurozone. What will emerge, if it is to survive, will be smaller and more focused around German financial and monetary disciplines

Read the rest of this entry »

Written by Jonathan Davis

November 10, 2011 at 3:02 PM

Thoughts on 1994

My latest FT column discusses the events of 1994, when the bond market blew a fuse and caused extensive losses for hedge funds, insurance companies and investment banks. While there are many differences between the events of that year and those of 2010, there are also some interesting parallels. In particular I argue that those who have been surprised by last week’s sharp fall in bond prices should not claim to be surprised. There is no historical precedent for such a view.

Nobody knows for sure whether the 28-year long bull market in Government bonds has finally ended (although it seems more than likely to me, as I am in the camp that fears inflation more than deflation from here), but the risks of another 1994-style episode are still considerable as and when interest rates eventually rise. With luck this time however the huge leverage that caused so much trouble in 1994 won’t be repeated. Surely the banks and brokerages that lent so recklessly to fund the leveraged bond positions of those who lost so much money in 1994 won’t make the same mistake again….for a while, anyway.

Written by Jonathan Davis

December 12, 2010 at 10:12 PM

Strange and wondrous times

In my latest Financial Times column, I argue that current market conditions are fascinating, but inherently unstable, because the Federal Reserve’s monetary policies have removed the traditional anchors on which investment decisions are traditionally made.  By chance I notice that Bill Mott of Psigma Investment Management, who has been managing equities even longer than I have been following the markets, has come out with a similar line of argument.

You can read all my FT columns and Spectator articles in an archive on the Independent Investor website. Here is a short extract from the latest one, which starts by recalling that even golden decades like the 1990s were punctuated by a succession of crises. I am also attaching a copy of Bill’s latest comments, which should be read in the light of the current fascinating stand-off between Ireland and the EU over how best to resolve its deepening banking problems, which I imagine will continue to weigh heavily on market performance for a while.

The striking thing about recalling these past episodes is that it is possible to make a plausible case that we could see an imitation rerun of nearly all of them in due course.  That the euro is ultimately vulnerable to fragmentation needs no elaboration, given the market’s run at Greek and now Irish debt. Some form of 1994-style rout in the bond market seems unavoidable in the next few years. The risk of a fresh market-induced disruption in emerging markets too, although it is almost certainly some way away, is also growing by the day.

The problem for investors is not that these risks are in any way concealed from view – in fact the more visible they are, the less of a concern – but that some tried and tested tools to analyse the right course through them are lacking. The consequence of the deliberate monetary stimulus now being masterminded by the Federal Reserve, and imitated in other places, is not just that it is distorting asset prices, but that it is also rendering useless the traditional anchors on which valuations and investment choices are based. Read the rest of this entry »

Written by Jonathan Davis

November 17, 2010 at 4:45 PM

The Coming Pain In The Bond Market

My latest Financial Times column discusses the outlook for the bond markets. Professor Jeremy Siegel says the bond market is a bubble and Nicholas Nassim Taleb says everyone should be betting against US Treasuries. I am of the same view, although precisely when the inevitable fallout occurs  is by the nature of markets uncertain, being intricately tied up with the ongoing inflation-deflation debate – more on this later. (All my FT columns, incidentally, are archived on the Independent Investor website and also on the FT’s own website).

A brutal May, a flat June, a happy July and then a lousy August – the equity markets continue to lurch alarmingly along a directionless path, with every monthly lurch seized on, by those with the strongest views, or at least the loudest megaphones, as evidence that their interpretation of events is right. It was not, fortunately, ever thus and nor will it be forever. In due course, we will find out in which direction the equity markets really want to go. My money still favours that direction being up, rather than down, but it could take one more painful downleg before the trend is finally established. Read the rest of this entry »

Written by Jonathan Davis

September 6, 2010 at 9:22 AM

Posted in Bond Market, FT Columns

Managing Money Is Not So Easy Anymore

Return figures for the first half of 2010 did not make for inspiring reading.  Government bonds performed rather well and some high yield and emerging market credits much better still. The main story however was one of renewed volatility and flatlining or declines by most asset classes.  July has so far been a different story however, with several key markets and risk assets turning sharply back up.

This patchy narrative is, frankly, not much of a surprise, given the nature of the economic conditions through which we are living.  Volatile markets moving sideways amidst continuing uncertainty about economic trajectories is very much what the “new normal” is meant to be about. It has not made managing money any easier however. Of more than 2700 UK funds monitored by Trustnet, for example, the median return year to date is just 2%.

According to the latest quarterly survey by Asset Risk Consultants, the average manager of sterling or dollar based private client assets gave back all or more of the gains that were eked out in the first quarter. For many hedge funds, the year has been a virtual washout, despite the fact that on paper volatile markets are meant to be the ones in which they should be thriving. Those dumb, derided retail investors who poured their money into bond funds for the moment look smarter than the pros.

Standing back from the fray, is it possible to see what is going on? While equity markets were clearly due a pause after their powerful recovery last year, investors remain mired in the fog of a seemingly unending struggle between powerful ongoing global deflationary forces and concerted Government and central bank attempts to head off the consequences through monetary expansion and (whisper it not too loudly) competitive currency debasement.

Read the rest of this entry »

Written by Jonathan Davis

August 9, 2010 at 12:36 PM

Siegmund Warburg and Investment Management

One of the intriguing issues raised by Niall Ferguson’s absorbing new biography of Siegmund Warburg is why someone regarded, rightly, as “the most important City figure of the postwar period” should have had such an apparent blind spot about the growth and profit potential of investment management as a business.

Peter Stormonth Darling, the chairman of Mercury Asset Management, the business that grew out of S.G.Warburg’s Investment Department, records in his memoirs how his first instruction on being told to take charge of this backwater in the bank was to “get rid of it”. In 1979 the business was offered, says Ferguson, to two rival banks, Flemings and Lazards, at a giveaway price of £10m. They were, he concludes, “foolish not to buy at the absurdly low price Warburg asked”.

(Editor’s subsequent note: In fact they were even more foolish than the book implies. According to the information I received from Mr Darling after this article appeared, the business was in fact offered to Flemings for just £1 and to Lazards for £100,000).

Even allowing for inflation, the asking price stands in striking contrast to the £3.1 billion for which the business was eventually sold to Merrill Lynch 18 years later. (A few years after failing to offload it, Warburgs floated the business on the London market as a largely independent business). More extraordinary still is that MAM’s exit price in 1997 was more than three and a half times that at which S.G. Warburg had itself been sold, somewhat ignominiously, just three years earlier.

As blind spots go, this therefore was something of a corker. Because shareholders in Warburgs retained a holding in MAM, to their eventual considerable benefit, the opportunity cost was nothing like as high as it would have been if the decision to sell had gone ahead. Yet Warburg’s decision was, as Ferguson makes clear, entirely consistent both with his own temperament and aspirations in business, and with the prevailing attitude in the City at the time towards investment management.

Read the rest of this entry »

Written by Jonathan Davis

July 19, 2010 at 9:33 AM

No More Prevarication on Public Debt

PAUL KRUGMAN, the Nobel Prize winning economist, was in top thundering form in his comments on the recent meeting of G-20 finance ministers, which – apparently prompted by the new coalition government in the UK – produced a noticeable change in political rhetoric by welcoming the plans by several countries to start tackling their hefty budget deficits.

“It’s basically incredible that this is happening with unemployment in the euro area still rising, and only slight labor market progress in the US” says Krugman.  Bowing to demands from the financial markets for fiscal austerity, in his view, is “utter folly posing as wisdom”.

“Don’t we need to worry about government debt?” he goes on. “Yes — but slashing spending while the economy is still deeply depressed is both an extremely costly and quite ineffective way to reduce future debt”. The right thing would be to wait until after the economy is strong enough to allow monetary policy to offset fiscal austerity. “But no: the deficit hawks want their cuts while unemployment rates are still at near-record highs and monetary policy is still hard up against the zero bound”.

The intellectual credentials of Prof Krugman are scarcely in question. But is he right to warn that even starting to tackle the fiscal imbalances today dooms us to another recession, or even depression? Without getting into a futile doctrinal debate between followers of Keynes and the Austrian school of economists, the alternative view, much more popular in the circles which I frequent, is that tackling debt with yet more debt is a far surer way to long term ruin. Postponing the evil day, after all, was at the heart of the Federal Reserve’s failings in the later years of Alan Greenspan’s tenure and helped to land us where we are today.

Not even to begin laying the ground for reductions in public spending today, let alone to confront the huge unfunded liabilities that lie beyond budget planning horizons, makes little sense. On past form it will take years for any cuts announced today to be fully implemented, if indeed they can be achieved at all. Just as 364 economists turned out to be wrong when they denounced Sir Geoffrey Howe’s infamous 1981 UK budget, it is not axiomatic to me that Prof Krugman and co are right this time round.

In any event it is surely debatable to blame the imminence of spending cuts mainly on pressure from the financial markets. It is not, after all, as if the “bond market vigilantes” have been much in evidence recently. Long term bond yields have been falling, not rising – foolishly, history may yet judge. Pointing out the inconvenient fact that Greece and other countries have unsustainable fiscal problems is meanwhile hardly an insight confined to a few hedge fund managers.

What really seems to affront the liberal academic mind is the idea that financial markets – irrational, greedy and capricious as they indubitably can be at times – should be seen to be driving public policy in any way. Unfortunately, a good deal of the argument about fiscal consolidation is about the timing of economic recovery, the appetite for risk in the private sector and the second and third order effects of fiscal tightening. This kind of judgment, in my experience, has never been the forte of economists, whatever their school.

Unsurprisingly perhaps, I take more comfort from Paul Volcker, who as a former Chairman of the Federal Reserve has a gold-plated track record in dealing with the consequences of past financial excess (and was rightly lauded by Prof Krugman, among others, for that achievement). In an excellent recent article in the New York Review of Books, after discussing his plans for banking reform, Mr Volcker observes: “The critical policy issues we face go way beyond the technicalities of law and regulation of financial markets”.

“If we need any further illustration of the potential threats to our own economy from uncontrolled borrowing, we have only to look to the struggle to maintain the common European currency, to rebalance the European economy, and to sustain the political cohesion of Europe. Amounts approaching a trillion dollars have been marshaled from national and international resources to deal with those challenges. Financing can buy time, but not indefinite time. The underlying hard fiscal and economic adjustments are necessary”. 

That sentiment is surely unquestionable. It is only recently however that political rhetoric across the indebted developed world is starting to match up to the scale of the challenge; and even then, it has to be said, the degree of realism that is on public display is often all too closely tied to the imminence of elections. President Obama’s intemperate attack on BP for its failings in the Gulf of Mexico shows that the syndrome is as true in Washington as it is in London, Frankfurt and Athens.

“As we look to that European experience” says Volcker “let’s consider our own situation. We are not a small country highly vulnerable to speculative attack. In an uncertain world, our currency and credit are well established. But there are serious questions, most immediately about the sustainability of our commitment to growing entitlement programs. Looking only a little further ahead, there are even larger questions of critical importance for those of less advanced age than I. The need to achieve a consensus for effective action against global warming, for energy independence, and for protecting the environment is not going to go away. Are we really prepared to meet those problems, and the related fiscal implications? If not, today’s concerns may soon become tomorrow’s existential crises”.

Mr Volcker also draws on a recent visit to Ireland to justify his view that optimism is not entirely out of place in this critical environment for policymakers. “It’s a small country, with few resources and, to put it mildly, a troubled history. In the last twenty years, it took a great leap forward, escaping from its economic lethargy and its internal conflicts. Responding to the potential of free and open markets and the stable European currency, standards of living have bounded higher, close to the general European level. Instead of emigration, there has been an influx of workers from abroad”.

“But now Ireland has been caught up in its own speculative excesses and financial deficits, culminating in a sharp economic decline. There is a lot of grumbling, about banks in particular. But I came away with another impression. The people I spoke to had an understanding that the boom had gotten out of hand. There seems to me a determination to do something about the situation, reflected not just in the words of the political leaders but in support for action among the public. And there is a sense of what is at stake, that the gains they made in recent years have been placed in jeopardy. The urgent need to get back on a sustainable budgetary and economic track is well understood”.

Not so, of course, in the United States. “Restoring our fiscal position, dealing with Social Security and health care obligations in a responsible way, sorting out a reasonable approach toward limiting carbon omissions, and producing domestic energy without unacceptable environmental risks all take time. We’d better get started. That will require a greater sense of common purpose and political consensus than has been evident in Washington or the country at large”.

There is no doubt that the hand of history is sitting heavily on the shoulders of the current generation of political leaders. They have critical judgments to make, and insufficient evidence to be sure that their decisions will turn out right. Mistakes are inevitable. The markets certainly have no monopoly on wisdom either – just look at their apparent readiness to lump in Hungary, a paragon of virtue in fiscal terms, with Greece. But the time for procrastination, as Mr Volcker is right to observe, is passing.

Written by Jonathan Davis

June 14, 2010 at 1:24 PM

A Polemic About IFA Commissions

It is nearly 40 years since Charley Ellis first categorised investment management as a “loser’s game”.  Many institutional investors have now taken on board that counter-intuitive message – but how many financial advisers have also absorbed the fact that an advisory proposition that explicitly or implicitly promises clients they can pick funds which consistently beat the markets after costs is a near-certain losing proposition in the long run?

The FSA’s Retail Distribution Review has perforce brought home to many IFAs the need to recalibrate their business models. The plan to phase out the practice of advisers taking commission from retail products on which they give advice from 1 January 2013 is a potentially game-changing event, although a number of details still remain to be finalised. As it will only apply to new advised business from that date, the effects will not be instantaneous. Trail commissions on legacy and execution-only business will continue to support IFA livelihoods for a while.

In that sense the RDR is not such a potentially dramatic change as, say, Big Bang. Personally, I find such gradualism rather too British for my taste. Like any worthwhile reforms, an assault on commission-driven advice, messy and liable to unintended consequences though it will undoubtedly be, should have happened long before now. It is a fact of life that well-funded industry lobbyists will always argue for delay and compromise, even when faced with the most common sense proposals. For evidence, just look at the forces of reaction queuing up to resist the idea of separating retail and investment banking once more, where there has surely rarely been a more clear-cut case for reform.

Sometimes important issues really are simple, and the inherent faults in commission-based financial advice constitute one such issue. To my mind the issue is not so much whether adjusting the commission system will lead to changes in the standard industry business model, as it clearly will, and clearly should, but whether it will in practice also lead to a change in advisers’ fundamental belief systems – the point being that running a commission-based advisory business effectively forces you to nail your colours to investment solutions that are often sub-optimal, and in defiance of all known experience.

There is a reason after all why index funds, ETFs and investment trusts, which generally pay no commission, still find little favour in IFA client portfolios.  Active fund management is not of itself an indefensible proposition. I am certainly persuaded that there are some active fund managers whose funds are worth owning (and I own a number myself). Multi-managers also have a role in matching funds to client objectives.

The question however is what role those funds should play in a client’s overall portfolio. The evidence that clients’ core exposure to the main asset classes is best obtained through low cost passive instruments is simply too overwhelming to be ignored. An adviser who is genuinely acting out of a sense of fiduciary duty to his client can no longer reasonably fail to acknowledge that fact. 

Over the five years to end 2009, according to Standard & Poor’s definitive semi-annual survey, more than 60% of actively managed and 70% of fixed income funds in the US failed to beat their benchmark indices. A recent academic study of the UK fund market confirmed the well-known US finding that most fund investors fall short of the performance of the average fund, in the UK case by some 2% per annum. 

There are two fundamental problems with the current system. One is the obvious one that advisers who are solely dependent on commissions are inevitably to some extent compromised by that fact, whether or not their clients in their ignorance prefer it that way. In a fee-based reward system, advisers can of course choose to rebate part or all of any commissions they receive to their clients, and some do, although this practice could, oddly, also be phased out in the UK by the RDR.

The second more fundamental problem is that fiduciary duty in the accepted legal sense is not a concept by which financial advisers appear to be legally constrained. (Suitability of products and other FSA criteria are weaker tests). Clients are often ignorant and the decisions that they should be most concerned about, which principally means asset allocation, are unfortunately the ones they understand least and are paradoxically the ones most poorly remunerated by the market.

Mr Ellis’ view is that advisers who understand the Loser’s Game and build their advice around that belief can not only go to bed every night with a clear conscience and a sense of professional pride, but are more likely to stay in business for the long term. It seems that Vanguard, of which Mr Ellis is now a director, is making that pitch a key part of its proposition as it attempts to break into the UK retail funds market.

In the United States, it reports, only 12% of firms in wealth management now base their pitch on superior performance. Service is instead the key criterion. By including a bigger chunk of indexing in their client portfolios, many advisers are discovering not only that their clients are doing better as a result, but that the risk of being fired by the client is also diminished.

In an ideal world, good advisers would become wealthy not, as now, merely for giving advice to as many clients as possible, but for giving the right advice – a fundamental difference. Nobody of common sense should fear such an outcome. But there is still a long way to go before that becomes a reality. Whether the RDR does the job remains for now still a hope rather than a certainty.

Written by Jonathan Davis

May 24, 2010 at 4:00 AM

Posted in FT Columns

Take The Bookmakers Over The Polls Any Day

The general election has thrown up many interesting issues for investors, but none was so marked as the continuous disparity, up to and including polling day itself, between the outcome in seats implied by the opinion polls and many electoral pundits and the different outcome that was forecast throughout in the odds quoted by bookmakers and on the betting exchanges.

It has been an article of faith of mine for years that, given a choice between the polls and the betting market, or between the odds and “expert opinion”, the punters are the group to follow. That approach rarely lets you down, and the result this time round again largely vindicates it, with the Conservatives emerging as comfortably the largest party with something close to an outright majority. While the exit poll on election night proved very accurate, the bookmakers gave the most consistent tracking of events during the campaign, with the Tory number of seats never once falling below 300, even at the height of Cleggmania. 

Until now however, I have never given much thought to why betting markets should be better at the prediction business. It seems obvious that the rapid growth in the betting market, and in particular the arrival of the betting exchanges, which allow significant sums to be wagered on events such as elections without the traditional bookmaker’s take, has transformed the depth and validity of the informational content implicit in the odds. 

But while that must be true, the change may still only be a matter of degree rather than a purely new phenomenon. Three years ago Professor Leighton Williams of Nottingham Business School, who researches both gambling and political forecasting,  published an interesting paper which suggested that bookmakers – who are, let us not forget, one of the oldest professions in the world -  have long held an edge over both opinion polls and expert opinion when it comes to predictive power.

His research, drawing on betting records, showed that in all the US Presidential elections between 1868 and 1940, the era before opinion polls, only once did the candidate who was favourite in the betting a month before the poll fail to win the election. (The exception was in 1916, when the incumbent Woodrow Wilson came from behind to pip his now forgotten challenger at the post).

Since then, despite the arrival of the opinion polls and the much greater media interest that is customarily accorded to them, in almost every fair contest the betting markets have comfortably outshone all competitors in the predictive business. In 2004, one of the two main predictive exchanges that are allowed to take political bets in the United States, “went stratospheric in predictive accuracy”, according to Prof Vaughan Williams, by predicting the winner in every single state while a number of pollsters and pundits continued to favour Kerry over Bush right up until polling day itself.

“Just think if you had an accumulator bet on that!” Prof Vaughan Williams enthused last week, as we chewed over the odds before the result was known. In his ranking of methodologies, Prof Vaughan Williams puts the betting exchanges at the top and, gratifyingly for another long held prejudice of mine, econometric models at the bottom. He believes that Betfair and other exchanges which do not limit the amount that can be wagered on political outcomes, as happens in the United States, are potentially more accurate as a result. The heavier the bet, by and large, the greater its predictive power.

There are good reasons why, absent manipulation, betting odds should often do so well. Unlike say the Grand National, general elections have very few potential winners and the odds are ultimately set by those with superior professional knowledge – which means principally those who have access to detailed information on the ground, such as canvas returns.

With opinion polls, however, there is the permanent problem that those invited to offer an opinion are not selected because they are likely to know something; an opinion poll has to be random to be statistically valid. At the same time, there is no penalty for giving an inaccurate or false reply. The “shy Tory” phenomenon, for example, seems to explain the mild understating of the Conservative vote in 2005.

Taken collectively, the opinion polls in a general election are often accurate within their margins of error about the percentage of votes cast. Translating that into seats won requires more specialist or local knowledge than a simple read across, assuming a uniform national swing, allows. This is the other main reason that the results derived from the polls by the media and the general public are so often misguided – the obvious question being why, if this is now so well known and accepted, misinterpretation continues to leave money on the table for those who know how to read the runes more accurately.

Written by Jonathan Davis

May 10, 2010 at 8:43 AM

Posted in FT Columns

Madoff And The Whistleblower

What are the lessons of the Madoff scandal? The more that comes out about this incredible story, the more complex and intriguing it becomes. Harry Markopolos, the whistleblower who tried unavailingly to get the SEC to investigate Madoff over more than 15 years, sub-titles his book about the affair “a true financial thriller”. And so it is, with the twist that the book is a story not of triumph, but of heroic failure to persuade anyone to take seriously his well-founded allegations that Madoff was a fraudster on the grand scale.

Taken together with the SEC inspector general’s damning report into the SEC’s failings published last year, it provides more disturbing evidence that the real world can often be crazier than the way it is portrayed in drama or fiction. Small wonder that the first people to queue up to watch Enron the play or Wall Street the movie are professionals, or that the Liar’s Poker and Barbarians At The Gate remain essential sourcebooks for anyone wanting to understand the extremes to which unfettered capitalism can be taken.

Some of the details in No One Would Listen, Mr Markopolos’ highly readable book, are beyond invention. For example, having failed to get the SEC interested in his original allegations, he turns to the media for help and eventually prompts MAR Hedge, a specialist hedge fund publication, to run a story raising questions about Madoff’s performance. A similar story appears shortly afterwards in Barron’s. He and the informal team of former colleagues who pursue their futile crusade against Madoff wait triumphantly for the SEC to take action, convinced that it cannot ignore such public exposure.

But what happens? Nothing. According to Mr Markopolos, the SEC does not even subscribe to specialist industry publications. Staff members have to pay for their own media subscriptions, even for the Wall Street Journal. A specialist publication such as MAR Hedge costing more than $1,000 is simply not on anyone’s reading list.

Why was the SEC so reluctant to investigate the allegations that the split strike options strategy Madoff claims to be running was too implausible to be genuine? Too many lawyers is the first item on Mr Markopols’ lengthy charge list. All the key people in charge of the potential investigation, he points out, were lawyers rather than financial experts. Ignorance, turf wars and lack of resources also played a part. When staff needed to research what derivatives were, in the absence of an investment library they had to rely on Google and Wikipedia.

The agency was also too quick, it appears, to dismiss Mr Markopolos as a bounty hunter with a grievance rather than as a serious investigator. Madoff himself had few fears of the SEC, whom he derided as useless. As the owner of one of the largest broker-dealers in New York, he was already such a big fish in the securities industry that only the bravest of regulators would be willing to take him on. (Since the crisis, as always happens, the incentives for regulators to seek big scalps have dramatically changed, as recent events have demonstrated).

The MARHedge article on Madoff appeared in 2001, by which time he was already running what was effectively the largest hedge fund in the world, with more assets than George Soros or any other much better known names. Yet because of the secrecy requirements that Madoff imposed on anyone who put money into his bogus strategy, and his refusal to charge fees, his name did not even feature in the MARHedge database at the time.

Mr Markopolos is right to say that the scale and durability of Madoff’s scam raises troubling issues for the financial services industry. By the time he turned himself in, Madoff was taking money from more than 330 feeder funds of funds in over 40 countries; yet many of them continued to believe that they had exclusive or preferential access to his impressive but non-existent winning strategy. Their claims to have carried out exhaustive due diligence were risible.

At the same time there were many on Wall Street who knew that there was something not right about what Madoff was doing, and steered well clear. Some invested anyway, believing that whether it was front-running or some other improper activity, they would rather not know as long as the returns kept racking up. The irony is that Mr Markopolos himself only first took an interest in Madoff because his employer kept badgering him to try and replicate what Madoff was doing. Yet nobody else felt it worth their while to expose him.

The Madoff story is ultimately a story about breach of trust. Investors were naïve to trust Madoff, naïve to trust the intermediaries who channelled money to him in such prodigious amounts, and naïve to believe that regulators could or would stop such an accomplished liar and conman. In Mr Markopolos’ view, although the majority of individuals in the financial services industry are honest, incentives to cut corners and breach both client trust and regulations are hard-wired into the system they work in. Which of us, hand on heart, knowing what we do, can deny that there is some truth in this?

Written by Jonathan Davis

April 6, 2010 at 9:51 AM

The Costs Matter Hypothesis

Although nobody much believes in the Efficient Markets Hypothesis any more, its lesser known cousin the CMH appears to go from strength to strength. CMH stands for the Costs Matter Hypothesis, and was first promulgated by Jack Bogle, the combative founder of Vanguard. It asserts that the one certain element in fund performance is the bite that fees and other costs will take out of the returns that the investor’s money earns.

Like death and taxes, which are anything but hypothetical, fund costs are one of nature’s few sure things. Mr Bogle likes to call them the “croupier’s take”. As in the casino, they are capable of imposing a serious drag on performance. Costs are irrecoverable and compound over time. In their Global Investment Returns Yearbook, Dimson, Marsh and Staunton estimate the long run cost of holding equities through funds to be in the region of 3% per annum. At that rate costs will eat up 27% of your starting capital over 10 years and almost half the long run annualised historical equity risk premium.

As certain as fund costs are, the paradox is that measuring exactly how big a bite costs take out of a fund’s performance is anything but. Meaningful standardised information on the true cost of fund ownership, as the FT regularly points out, is hard to come by. The current regulatory requirements on funds to publish Total Expense Ratios and deceptively mild Reduction in Yield figures (whose significance no investor I have ever met seems to understand) fall well short of full transparency.

Mr Bogle and other proponents of the CMH point out that, among other hidden cost items, TERs do not include the impact of direct and indirect transaction costs, an important omission in an era when the portfolio turnover of the typical fund has fallen to less than a year. The “true” cost of owning an actively managed fund can therefore be much higher than its reported TER suggests. So much is of course common knowledge on the supply side of the industry.

According to Alan Miller, who runs low cost funds at a boutique firm, SCM Private, the simplest methodology for seeing how far these two effects can combine to rob the investor through needless expense was developed by an American academic, Professor Ross Miller (no relation) and published in 2005. It was designed to arrive at a “true cost” and “true alpha” figure for US mutual funds.

The only three required inputs are a fund’s published TER, its r-squared (correlation with the index) and the reported alpha, as calculated by Morningstar. The “true cost” is derived by taking the difference in cost between the TER of any given fund and that of an appropriate low cost index fund alternative and in effect applying this difference to that small proportion of the fund which the r-squared analysis suggests is the only genuinely actively managed component of the portfolio. By stripping out the passive component from the reported alpha, you can also calculate the “true alpha” of each fund.

The original results were striking in highlighting the difference between apparent and “true” performance. The average large cap mutual fund in the US, the Prof Miller found, had an r-squared of 0.96 in the three years to 2004, making it all but impossible for them to produce anything materially different from the performance of an S&P 500 index fund. The “true TER” of this kind of fund was nearly 7% and its “active alpha”, on his numbers, a startling minus 9.0%.

“In essence” he concludes “large cap funds taken as a whole consume 7% of the assets being managed as expenses and then generate another 2% of losses beyond that”. Back in the UK, with all the zeal of a former active fund manager who has since repented, Mr Miller has used the methodology to calculate similar adjusted figures for the TERs and active alphas of mainstream funds in the UK.

Using three-year performance figures, he finds that the “active expense ratio” of the average fund in the UK All Companies Sector is around 6%, or nearly four times the average reported TER of 1.6% p.a, while the “true alpha” is minus 3.8%. Although this methodology is open to criticism, the results are consistent with the known facts. The average equity fund in the All Companies sector, like the average US equity mutual fund, underperforms its benchmark to the extent, more or less, of the industry’s average costs. Five year data produces a similar result.

To be fair, scanning the 233 UK funds in Mr Miller’s sample suggests that some houses do have a number of funds which score well on both measures. With positive true alphas, even the more expensive ones can at least be said to doing something to earn their share of the croupier’s take. Schroders, Jupiter and Threadneedle are all examples.

But there is a much larger number of funds, many with substantial amounts of assets, whose results on this methodology look shockingly poor. They make a compelling case for more meaningful regulatory disclosure. The CMH in any event stands vindicated once more.

If you would like to see the full list of funds, as analysed by Alan Miller, please email me

Written by Jonathan Davis

March 21, 2010 at 8:46 PM

Posted in FT Columns, Jack Bogle

The End Of An Era For Bonds?

The toughest questions in investment are not those that challenge specific views, but those that challenge deep-seated assumptions. Markets exist to accommodate a range of participants with divergent views or economic interests, so it is hardly a surprise that almost any position can be justified somehow. Those who judge the position right are rewarded, while those who do not are penalised.

But that is not how the most grievous or most costly mistakes are made. Those arise when it is investors’ entire belief systems that turn out to be misplaced. LTCM is a good case in point. Clever to a man, the principals lost their business because their faith in historical relationships that had worked so well for many years turned out in practice to break down during a period of extreme market stress.

The same, on an even bigger scale, goes for central bankers who bought in, naively, to Alan Greenspan’s convenient view that bubbles in financial markets could not be identified in advance and even if they could, would prove more costly to pre-empt than to clear up after they had burst. As he confessed to Congress in October 2008, bankers’ behaviour during the crisis had revealed “a flaw in the model … that defines how the world works”. The cost to the world of the chairman of the Federal Reserve’s faulty assumption now runs into billions.

Are we now approaching the point with Government bonds where the assumptions that have carried this once derided instrument triumphantly through three decades of consistently good returns need to be discarded? If we are not there already, we are surely not that far away. A recent report by Andrew Smithers posed the question bluntly: “ Bonds – Government and Corporate, Nominal and Real – Why Should Anyone Hold Them?”

His argument is that at current levels Government bonds are “seriously overpriced” and therefore high risk. Returns are likely to be negative in the short term as the twin props of quantitative easing and bank window-dressing are withdrawn. Yields on inflation-linked bonds meanwhile have been driven so low by investors seeking insurance against a resurgence of inflation that, in his view, they are set to do badly whether or not inflation picks up.

Dimson, Marsh and Staunton are just as blunt in their latest Global Investment Returns Yearbook. They note that in defiance of financial theory, over the 40 years to the end of 2008 government bonds outperformed equities. Their world bond index produced an annualised real return of 4.89% between 1969 and 2008, compared with an annualised real return of 4.02% for equities. The long run real historical return from government bonds since 1900, in contrast, a period that incorporates the full gamut of human experience, including two world wars, has been just 1.0% per annum.

It is true that the anomaly of bonds outperforming equities over long periods has reversed after last year’s equity market revival, but it remains the case, the professors note, that “in an apparent violation of the law of risk and return” (than which nothing of course is more offensive to the academic mind), bonds have “produced equity-like performance, with annualised returns just a little below those on stocks, yet at much lower volatility”. Extrapolating these high returns in the future would, they conclude, “be fantasy”.

They are right about that. With 10-year yields at 3.8% in the United States and 4.0% in the UK, to project a 4.0% annualised real rate of return from Government bonds at these levels only makes sense if the world is heading for outright deflation, a fast receding possibility. Even if that were to happen, the boost to bond returns would at best be a transitory one.

In fact, from a valuation perspective it is hard to construct a plausible world economic scenario which would validate buying Government bonds today other than as a short term tactic. It is true that bonds were one of the few asset classes to display diversification value during the global financial crisis. Diversification remains the other prop, besides disinflation, on which investors’ faith in Government bonds rests.

But even this, an article of faith for entire generations of investors, is open to challenge. For Mr Smithers, the argument cuts little ice. As an instrument of diversification, cash shapes up at least as well as bonds, notwithstanding the current miserly returns on short term deposits. The huge supply overhang that is implicit in the ballooning fiscal deficits in the US, Europe and the UK meanwhile seems sure to drive yields higher. When is a only matter of time and degree.

It is not that investors who buy bonds today cannot experience one last hurrah before the 30-year cycle turns for good. There will always be opportunities to play the yield curve (now much steeper than its historical average) for profit. The message is rather that the returns of the last 30 years on which many market participants’ investment philosophy is based cannot and will not be repeated over the next 30, with all the implications that must flow from that statement.

Written by Jonathan Davis

March 8, 2010 at 4:26 PM

Politics Is Back In Vogue (FT Column)

If you are not a fan of forecasting, and have no reason to be sure what is going to happen over the next 12 months, it makes a lot of sense to start the year, not with a set of predictions but with two lists – a wish list and a watch list. As well as being good for the spirits, positive thinking is helpful from a risk perspective. It is much easier psychologically to take precautions against a wish not happening than it is to assume that a public prediction will turn out to be wrong.

This, in any event, is very much the way that many fund managers seem to operate. I have lost count of the number of times over the years that active fund managers are heard to say that what we are facing is a stockpickers’ market – or, to put it another way, a range-bound market that will reward those with suitable skills. As far as I can see, this more often than not is also wishful thinking.

Even if it is true in one year, it rarely is in the next. In 2009, did you need stockpicking skills to spot and ride the market rally? Not really. The most important thing was to be in equities at all, and then the best thing to do was chuck away your analytical sensitivities and pile into high beta stocks regardless of merit.

With the market having rallied so strongly since its lows in March, it is easy to say that 2010 will be different. The so-called “dash for trash” may already have run its course. Large cap quality stocks must be the better long term bet at today’s values, but that does not make it a sure thing that the rotation will persist throughout this year. 2010 has started with a bad January for equities and risk assets, which if you believe in such things, bodes ill for the rest of the year.

However these are early days,and although sentiment has clearly taken a turn for the worse in the last three weeks, with the hedge funds mounting a concerted assault on the risks of Government bond defaults in the Eurozone, it is still premature to write off the rest of the year. The Bank of England’s decision to call a halt to quantitative easing is a valiant statement of intent that it wants to return to more normal conditions, but it may yet be derailed by a return of investor nervousness. 

Meanwhile, whether or not you buy into Pimco’s “new normal” hypothesis, what is undeniable is that politics has returned with a vengeance to centre stage, and with it the parameters of risk are changing. With unemployment (or the fear of it, as in China) still running high, new political battle lines are already being drawn in many countries. The Massachusetts election result, to give one example, is clearly a potential game-changing event.

For central bankers and politicians alike, operating in unprecedented conditions with the usual inadequate data, the risk of policy errors remains extremely high. The government debt crisis towards which many countries are now hurtling presents plenty of opportunities for false steps, as well as a wonderful scare story for hedge funds to hunt down, as they are doing.

As experience warns us that this kind of environment is one that is full of perils for investors, a measure of caution is undoubtedly justified. In fact, it seems more likely that the markets’ nervous start to 2010 is best attributed to a heightened sense of political risk than to any change in corporate or economic fundamentals, where as far as can be told the recovery in the United States, at least, is so far well up to expectations, with two thirds of companies beating earnings expectations and support from a steep and rising yield curve. The Government debt issue itself is not news, but how well the markets think governments will react to the problem most certainly is.

Top of any wish list for 2010 must be a return to higher interest rates and rising bond yields. Although this prospect is something that seems to terrify many Western governments, faced with spiralling public debt, it is a essential pre-condition of the world returning to normality. A combination of unprecedented public sector intervention and artificially low interest rates, while it may be justified as a short term expedient, is a surefire path to misallocation of capital and economic stagnation. A failed political response to the debt challenge is the corollary for the watch list.

The risk to investors arises from the fact that, while the voters of Massachusetts seem to have recognised the dangers in fiscal irresponsibility, the administration in Washington does not yet appear to share that opinion. Equally concerning is the fact that the Federal Reserve and many other central bankers seem to have become dangerously fixated on low or even negative real interest rates at almost any cost, as if somehow that is a desirable norm, which it most definitely is not.

The point that should worry investors most is that politics is non-linear. The dynamics can change fast and in unpredictable ways. Politicians tend systematically to overlook the second and third order effects of decisions they make today. Given the likely volatility, the odds are that 2010 could be an eventful year, with an emerging story of better-than-expected recovery (as I see it) threatened by shifting investor worries, continued bank frailty and complex but interesting political and policymaking manoeuvring whose outcome is uncertain and imperfectly knowable.

Written by Jonathan Davis

February 8, 2010 at 1:24 PM

Put Not Your Trust in Forecasts

Never invest on the basis of forecasts. So says James Montier, recently anointed the dean of behavioural finance in the UK. Glance at the index of Value Investing, his superb collection of essays on the subject, and you will find that “forecast” appears more often than any other, with the exception only of the holy of holies, Ben Graham himself. References to the former are as consistently negative as those to the latter are positive.

“The evidence on the folly of forecasting is overwhelming” Montier concludes, whether you are talking about economists or stockbroking analysts. “Frankly the three blind mice have more credibility than any macro-forecaster at seeing what is coming” is his verdict on economists. As for analysts, he notes that the average forecasting error in the US analyst community between 2001 and 2006 was 47% over 12 months and 93% over 24 months.

And what does Ben Graham say? Simply this: “Forecasting security prices in not properly a part of security analysis”. Judging by the response to my last column, which described John Templeton’s approach to the forecasting business, this is a view that many participants in the securities business share. The only professionally acceptable response to any question on the subject of analyst reports is to say “Well, I read them – but only for the data, you understand, not for the recommendations”.

The only problem with all this is that it doesn’t seem to be true. It would be nice to meet a few professional investors who don’t in practice, either implicitly or explicitly, rely quite heavily on forecasts to inform and justify their investment views. This has prompted me over the years to formulate some other rules which I have found helpful in distinguishing between useful and useless research.

The first of these is this: “Don’t rely on what anyone says they are doing. Look at what they are actually doing”. Just as comment is free, but facts are sacred, so too market punditry is cheap, but actual investment decisions are the only thing that really matter. I recall a meeting of IFAs in March 2003 at which, on a show of hands, a clear majority of those present disputed a claim by Anthony Bolton that his then public bullishness on equities was a contrarian call.

A second show of hands then revealed that, although being bullish was what the majority professed to believe, only a tiny minority of those present had actually positioned their clients’ portfolios to reflect that view. While the audience was talking about loading up on equities, Bolton was one of the few who had already done so. A year later many in the audience were still struggling to catch up with the renewed bull market that they had called, but signally failed to act on.

A second valuable rule is “Never waste any time on investors who appear to be telling the markets what to do”. Saying something will happen is a good way to generate a headline, but a poor way to make money. Every investment call can at best be an assessment of probabilities. Those who proclaim that an outcome is a virtual certainty are either deluded (if they believe their own pronouncements), charlatans (if they don’t believe it, but go ahead and make it anyway) or professionals who are paid to believe it (brokers and headline writers being good examples). Those who are hesitant and make liberal use of phrases such as “my guess”, “the most probable outcome” and so on are the ones talking the true language of the market.

A third useful empirical rule is “Don’t use Japanese experience as proof of anything”. Many of us have fallen at this hurdle over the years. Just as the great equity bull market of the 1970s and 1980s powered on beyond any possible rationalisation, so too the subsequent 20-year period has been full of commensurate disappointments.

The Japanese economic experience of the last 40 years serves only to demonstrate that Japan, for reasons that are open to analysis, marches to different rules from almost every other market, society and economy. It is the exception to almost every rule in the book. Those who currently claim that the US must inevitably follow Japan into 20 years of debt deflation are breaking both the second and the third rule.

If forecasts are no use, then what is the basis on which investors can or should make decisions? Value has to be part of it. Momentum is also a useful tool: wonderfully consistent as long as it works and then periodically catastrophic when, as invariably it does, it breaks down. Technical analysis, if used as a guide to probabilities, has a place; ditto good fortune. A good deal of the time however, including most likely the present, markets can appear to be neither obviously dear nor cheap. Who, though, one wonders, is buying Government bonds today out of unalloyed conviction?

Written by Jonathan Davis

January 22, 2010 at 6:27 PM

John Templeton’s 2020 vision

The only sure way to make market forecasts that have any enduring value, I have learnt, is to follow the formula successfully deployed by Sir John Templeton. His technique was to look a fair way ahead and come up with a number that sounded impressively large – impressively large, that is, until you examined his assumptions and worked out what compound rate of return his forecast actually implied.

So for example with the Dow Jones Industrial Average at around 800 in 1980, having convinced himself that stocks were cheap, he boldly predicted that the market could reach 3,000 before the end of that decade, and could easily rise 20 fold by 2020. That sounded extraordinary at the time to a generation which had just survived the 1974-75 bear market.

Yet in practice, given his premise that inflation would continue to double the price level every ten years, the 3,000 figure represented a real compound rate of growth (after inflation) of 8% per annum. That was certainly some way above the long term average growth rate for US equities, as the historical average is a total return calculation.

But given that starting valuations in 1980 were already very depressed by historical standards, the headline-grabbing forecast was nothing like as wild as it might at first have appeared. For the Dow to reach 16,000 by 2020 from its current level of around 10,500, incidentally, it will need to rise at a compound rate of 4.5% per annum for the next ten years – so even though inflation has fallen dramatically in the interim, the original 1980 forecast is still by no means an unlikely target.

For good measure, although Templeton liked to give a specific end point to any forecast he made, he was too smart to commit himself more directly to when his target might be reached, leaving plenty of room for relapses and consolidations along the way. (A more cynical version of this approach to forecasting was summed up by the economist who said “if you have to forecast at all, forecast long and forecast often”).

What Templeton was however was a self-confessed optimist, who continued to believe right up until his death that, while the market would continue to suffer periodic setbacks of 30%-50%, those who predicted a new Great Depression were wrong. He had great faith in the hunger and resilience of the American people and in the capacity of humankind to make progress. Market setbacks were the price you paid for long term equity returns.

For example, in 1987, with what turned out to be uncanny prescience, Templeton said that he fully expected an imminent fall of 30%-50% in the market. It duly happened, but within weeks of Black Monday in October of that year he was reiterating his arguments about the Dow reaching 3,000, and celebrating the fact that investors had been given a second chance to get in on the ground floor of what he remained convinced would prove to be one of the greatest bull markets of all time.

The following year he became bolder still. His study of market history over many years had convinced him that bear markets rarely last longer than 15 months. If markets have not breached their previous low within 12 months, he argued, the odds are very high that they won’t go on to do so again. (If that assumption still holds, it makes it virtually certain that a new test of the March 2009 bear market lows is unlikely this time round).

Speaking in 1988, Templeton discounted the prevailing fears of doomsters of the day, arguing that all the major problems that preoccupied the markets at the time were already known and consequently priced in. “The fact that we have a terribly unbalanced federal budget” he told one interviewer “is already in share prices. The fact that we have a bad balance of payments in foreign trade is already reflected in share prices”.

It was wrong to assume that trade or budget deficits would lead to either depression or deflation. Anyone who studied financial history, he believed, would see that large budget and trade deficits only ever resulted in inflation. By the same token, like many of his generation, he was confident that politicians had learned the lessons of the Great Depression and would never allow the economy to slip into deflation.

Would he still think the same way today? He is not around to tell us, but close analysis of his thinking over many years suggests to me that notwithstanding the unprecedented scale of the global financial crisis, he would be on the bullish side of the consensus. Having clearly identified the severity of the looming housing market bubble five years ago, and seen the market tumble by 50% from its peak, I don’t think he would be betting against the resilience of the US economy now.

It is easy to be daunted by the enormity of the task that lies ahead. Where is the political will to eliminate the extraordinary pile of public sector debt that the crisis has engendered? Where will the jobs come from? How can future banking crises be averted if the banking lobby succeeds in blocking the reintroduction of a badly needed modern version of the Glass-Steagall Act?

We don’t know. Nothing can be ruled out absolutely. But without falling into the trap of making a specific year ahead forecast, the odds still surely favour the Dow making Templeton’s target of 16,000 before 2020 a very reasonable bet.

Written by Jonathan Davis

January 3, 2010 at 2:17 AM

A Positive Feel About Equities

While forecasting the market’s behaviour for the year ahead is a mug’s game, some good reasons are emerging for thinking that the recovery in the equity markets could have further to run in 2010. My most recent column in the Financial Times picks up on this theme, with reference to a recent visit to London by Bill Miller of Legg Mason.  The key point to note is that while many pundits are now belatedly talking bullish (normally a worrying sign), investors collectively are still not acting that way. Of course it will turn when the bond market finally seizes up, as all bets will then be off. In my view, however,despite the sudden strength of the dollar, we are not at that point yet. There is bound to be an early correction in 2010, but the year as a whole could easily accomnmodate a further 10%-15% rise.

A few years ago it was standing room only at the Savoy Hotel when Bill Miller, the celebrated manager of the Legg Mason Value Trust, came to London to impart his latest views on the market. While on his way to 15 successive years of outperforming the S&P 500 index, a feat that no other US fund manager has achieved in modern times, his fund rode a wave of popularity. As is the way, Miller’s every word on the markets was assured of a reverent hearing.

Last week, with the Savoy still out of action, Mr Miller made an altogether quieter appearance at the London Stock Exchange. Having misjudged the credit crunch, and seen his fund languish at the bottom of the performance league tables for many months, it was perhaps no surprise that only a handful of media turned up to listen to what he had to say.

Being both bullish about the equity market and happily out of step with majority opinion, Mr Miller’s views will struggle to gain traction for a while yet. At one point he compared the equity markets today with 1982, the year that the great bull market of the late twentieth century began. His point was not that the market conditions were identical at the time, but that if you looked at what analysts were saying about prospects in 1983, the list of potential negatives would have been as long  and sounded just as horrible as that which prevails today.

Could the analysts be just as wrong this time round? Being out of favour is no obstacle to being right. Indeed it is a badge of honour for the contrarian investor. Having earlier drawn attention to his fund’s troubles in this column, I feel it only fair to report that Mr Miller’s fund has outperformed the S&P index by 10% to date this year, reversing some at least of the losses of his annus horribilis in 2008. What is more, I am beginning to suspect that his judgment on equity markets, which proved to be so wrong during the crisis, will be proved to be right now that it is receding.

What are the arguments for thinking that the outlook for the equity markets is much better than the prevailing consensus? Reading across from valuation measures such as Tobin’s q and cyclically adjusted p/es, the market currently appears to be trading somewhat above fair value. If you take them at face value, estimates for the earnings of the S&P 500 in relation to the market’s level look unexciting.

But how good are those earnings estimates? Estimates are poor at the best of times, and particularly unreliable at turning points. Just as it took a long time for analysts to catch up with the scale of the decline in earnings in the immediate aftermath of the crisis, so too they have been slow to catch up with the improving trend since the recession ended earlier this year. In the second quarter of 2009, more than 75% of companies in the US came in with earnings that were ahead of analyst expectations.

At the same time it looks in hindsight very much as if corporate America, in common with investors themselves, reacted too sharply to the post-Lehman global financial crisis. The scramble to cut jobs, slash inventories and reduce debt has left many companies struggling to fill orders as demand starts to return. (Tim Bond of Barclays Capital makes a similar argument, pointing out that delivery times are currently lengthening, not shortening).

Another metric that Mr Miller points to is the ratio of expected earnings growth to GDP growth, which at around eleven times a “new normal” GDP growth estimate for 2010 of 2.4% is well above its historical average of six times. Yet he is of the school that believes that the scale of recovery in the US economy after recessions is typically proportionate to the severity of the preceding decline in output. As the US recession has been the worst since the 1930s, the scale and speed of the recovery is more likely to surprise on the upside than the downside.

If the historical analogy turns out to be correct, the implication is either that current earnings expectations are too high, or that GDP projections are too low. Mr Miller’s money is firmly on the latter. He expects technology, financials and consumer stocks to lead the stock market higher in 2010. IBM, he points out, has 100 years of earnings data, and is well known for the reliability of its earnings guidance. It is looking to continue growing its earnings at an annualised rate of 15% through next year. Yet its shares trade at a discount to the market, at a lowly 11x earnings.

The reality is that the future direction of financial markets is never a one-way, predetermined street. In a year’s time, if Mr Miller turns out to be right about the scale of the recovery in the economy and equity markets, as I suspect he may, those who have been left behind will surely conclude that they have allowed their judgment to have been impaired for too long by the lingering trauma of last year’s crisis. To put it another way, given a choice between betting that analysts’ forecasts are precisely right or that investor psychology is roughly wrong, the smart money rarely errs by choosing the latter.

Written by Jonathan Davis

December 16, 2009 at 11:13 AM

The Bubble in Gold Still Lies Ahead

There are many reasons why sensible columnists prefer to steer clear of writing about gold. One is that you get the weirdest responses. Twenty years ago they would arrive in funny shaped envelopes, often in green ink, often from individuals with extraordinarily peculiar views about the world. These days the risk is that anything you say will be instantly picked up, recycled and commented on in a thousand online blogs. Not all of that community, shall we say, are interested in constructive dialogue. Gold retains its capacity to excite the most extreme polarised views.

A second reason for thinking better of writing about gold is what one might call the Warren Buffett problem. When asked for his views about gold, he typically replies with the same answer, along the lines that gold has never been a good store of value and is unlikely ever to interest him as a home for his money. Gold, he says, ” gets dug out of the ground in Africa or some place. Then we melt it down, dig another hole, transport it halfway round the world, then bury it again and pay people to stand around guarding it”. It has, he argues, “no utility”. There will always be other things that he would rather own.

Although doing back-flips when circumstances change is one of Buffett’s greatest strengths, he appears to have been true to his word in never having made a significant investment in gold or gold shares. In the late 1990s, he did briefly place a large bet on the price of silver, based on a personal analysis of the supply and demand equation for the metal which turned out to be quite flawed. He has been known also to recycle Mark Twain’s famous description of a gold mine as a “hole in the ground with a liar at the top”.

If the world’s greatest investor doesn’t think gold deserves consideration, has he got a point? A serious criticism of gold is that it may not in the strictest sense be an investment, in the Ben Graham sense of generating returns that can be analysed and valued. It can be lent out, for sure, albeit for meagre returns, but that has to be set against storage and insurance costs. While physical supply and demand clearly play a part in determining the price of gold, its performance is increasingly influenced by fluctuations in demand from investors (which a Grahamite purist might label as speculative interest).

The arrival of liquid, freely tradeable exchange traded funds in precious metals, some but not all of which are backed by physical collateral, is further encouraging this trend. With the sharp run up in the dollar price of gold this year, coupled with a notable recovery in equity markets, new gold funds are emerging by the week. John Paulson, the hedge fund manager who did so well out of the credit crunch, is the latest to launch a gold fund. Such high profile launches can only heighten interest in gold and more highly geared gold shares, and might in normal times be seen as early evidence that gold is entering a speculative bubble and must therefore be heading for a nasty fall.

However these are far from normal times. While the seeds of a future bubble in gold are being sown, and the gold price will remain volatile, if only to relieve momentum-chasers of some of their money, on most measures we are a long way away from any kind of climax. Despite growing media attention, gold remains surprisingly underowned by private investors. More people talk about it than actually own it in volume. Every trend-following speculator who is buying gold today for bandwagon reasons is, I suspect, comfortably matched by seasoned wealthy and professional investors accumulating gold for traditional defensive reasons, not to mention central banks desperate to reduce their dollar dependency.

Whether or not you care to define it as an investment, gold offers protection against the devaluation of the dollar and the eventual re-emergence of inflation that Buffett himself has identified as the inevitable consequences of the financial crisis and governments’ response to it. While he may be right that buying the Burlington Northern railroad is a better way to profit from eventual recovery in the global economy, the rest of us mere mortals will not be easily convinced to dump our gold and other commodities for some while yet.

Putting your head above the parapet and admitting to owning the barbarous relic and inviting all the unwanted attention that comes with such a public confession of unorthodoxy is one of the costs of ownership. The point about gold is not to own it for some ineffable or intrinsic reason, as gold bugs do, but because today’s unprecedented economic conditions make it a sound and defensible two way bet on the future. If gold’s time is ever going to come, we are living through just such a time now. The real gold bubble still lies ahead.

Written by Jonathan Davis

November 22, 2009 at 10:35 PM

Posted in FT Columns, Gold

The 1930s Revisited

After all the publicity that it has already generated by being chosen as the FT/Goldman Sachs business book of the year, it may seem redundant to heap more praise on Liaqat Ahamed’s book Lords of Finance, which tells the story of how the four most important central bankers of the day struggled – and ultimately failed – to prevent the financial and economic crises that culminated in the Great Depression of the 1930s.

Yet it seems to me that the study of financial history remains so central to the achievement of investment success that further mentions of this outstanding work are not only defensible, but necessary. Lords of Finance is a splendid illustration of the value of historical narrative in throwing light on the complex and dynamic factors that shape the economic and financial environment, and provide an important perspective on the current outlook for equity, bond and currency markets.

In investment, so much good financial history has appeared recently that one has to hope the study of history, and other thriving disciplines such as psychology and behavioural science, will create a better understanding of the roots of market behaviour. This follows a period in which misguided reliance on quantitative techniques and simplistic, unprovable theorems has by common consent contributed to the unprecedented financial traumas of the past two years.

In the evolution of the global financial crisis, central bankers have played a central role, which makes Mr Ahamed’s book, although it was largely completed before the collapse of Lehman Brothers, timely. A year on, the parallels between the issues facing the four central bankers who are central to his story (Montagu Norman at the Bank of England, Benjamin Strong of the New York Fed, Emile Moreau at the Banque de France and Hjalmar Schacht of the Reichsbank) and those facing their counterparts today are all too obvious.

One of the strengths of Lords of Finance is that it demonstrates that central bankers have never been the heroic figures of omniscient authority that Alan Greenspan was for some years, absurdly, depicted as being. It is true that in the 1920s none of the central banks in the US, Britain, Germany and France had the experience, let alone the powers, that they enjoy today. The Federal Reserve, founded in 1913, took years to find its feet, its early years memorably described by J.K. Galbraith as “a body of startling incompetence”.

But in other ways the central bankers of the 1920s had a much easier time than their modern successors, who have to cope with media exposure and the infinitely greater complexities of modern globalised markets. Mr Ahamed has a particularly good eye for the telling anecdote about his protagonists, who include not only the central bankers and statesmen of the day, but other influential contemporaries, of which John Maynard Keynes inevitably commands the greatest attention.

This, for example, is Mr Keynes in June 1931, shortly before Britain finally abandoned the Gold Standard, the prop on which its policy had so stubbornly relied for too long: “We are today in the middle of the greatest catastrophe – due almost entirely to economic causes in the modern world. I am told the view is held in Moscow that this is the last, the culminating crisis of capitalism, and that our existing order of society will not survive it.”

There were some only months ago who felt something similar, although it is worth making the point that Mr Keynes had originally not been totally opposed to the Gold Standard before changing his mind as the 1920s unfolded. Those who today put forward Keynesian solutions from the 1930s rarely allow for the fact that he would almost certainly have had his own original ideas for resolving the current crisis, which might have been very different from the ones he expounded 70 years ago.

It is impressive too to learn of the British Ambassador’s superbly robust contemporary assessment of the German central bank’s disastrous monetary policies after the first world war, which paved the way for hyperinflation and the rise of Hitler. “No one could anticipate such an ingenious revelation of extreme folly to which ignorance and false theory could lead . . . The Reichsbank’s own demented inspirations gave stabilisation no chance . . . It appears almost impossible to hope for the recovery of a country where such things are possible”.

Mr Ahamed is rightly keen to stress that the lessons from a study of the Great Depression are not as simplistic as Milton Friedman and many others would have us believe. Nevertheless his conclusion is blunt: “The Great Depression was not some Act of God or the result of some deep-rooted contradictions of capitalism, but the direct result of a series of misjudgements by economic policy makers, some made back in the 1920s, others after the first crises set in – by any measure the most dramatic sequence of collective blunders ever made by financial officials.

“More than anything else, therefore, the Great Depression was caused by a failure of intellectual will, a lack of understanding about how the economy operated.”

Just as the boom of the later 1920s convinced the world that the fatally flawed Gold Standard regime might have created a new economic order, so we will surely look back on the years of the Great Moderation in time to come and conclude that it was another failure of intellectual will that sowed the seeds of our current problems. Nor, if history is any guide, are those troubles remotely over, however reassuring the government-sponsored market rally of the past nine months may be.

Written by Jonathan Davis

November 10, 2009 at 9:59 AM

No Time For Regrets

“Regrets – I have had a few, but then again too few to mention…..” Happy the fund manager, policymaker, or retail investor who could, hand on heart, echo the sentiments of Frank Sinatra’s signature tune. They may do it their way, but it is rare indeed for that way to be free of regrets. More often, the regrets are too many, not too few, to mention.

It took me many years to realise the force of Charlie Munger’s observation that the aim of investment is to minimise regret, or (if you prefer) to minimise the opportunity cost of the decisions that you make. Acting in good faith is a necessary but sadly insufficient condition for achieving successful long term results. Quality of thinking, provided that includes retrospective analysis, and temperamental maturity matter much more.

Keeping the concept of minimising regret in mind can lead to some powerful changes in emphasis and approach. Just as corporations rarely spend much time analysing the outcome of their investment decisions, which condemns them to repeat them again in future, so professional investors are typically far more interested in analysing the next good thing at the expense of understanding why the last good thing turned out to be so disappointing.

Yet the latter approach will never be time wasted. The strength of the recent equity market rally provides a perfect example. Only those who had experienced or studied the way that previous bear markets end are likely to have avoided being caught out by the force of the recovery, which has sent emerging market equities up by 80% in some cases, and the S&P index by 50% from its March lows.

The process may still not be over, as there remains plenty of uninvested cash sitting on the sidelines in institutional and discretionary accounts. As the year end approaches, fund managers who have been left behind are suffering huge dollops of regret. The chances are however that unless they absorb the lessons of their failure to spot the change in market dynamics this time round, they will be condemned to make the same mistakes again in future.

For the retail investor, the paradox is that the regulators’ sensible (but largely futile) strictures against reliance on past performance may also have a downside, if the message obscures the fact that analysing past performance – especially disappointing past performance – is an essential prerequisite to doing better in future. It seems hard to believe how, if there was a readily accessible independent service that analysed the true cost of employing wealth managers, for example, many of those in the business could possibly survive.

A survey of 238 private banks and wealth management firms by Pricewaterhouse Coopers in the United States earlier this year found that around a third of those surveyed did not themselves believe that they were fully qualified to do the job. This may be a shocking finding, but it is not one that anecdotal evidence suggests is unfair. While more clients of wealth managers than before confess to be disappointed with the service they receive, many remain ignorant of just how bad and expensive that service is.

It is a similar story with active fund management. Compared to 20 years ago, there is no doubt that awareness of the importance of costs is much greater than it was, but the persistence of so many expensive funds that deliver below par performance is striking, despite disclosure requirements that make the potential impact on total returns explicit (or would do if anybody bothered to read them). Once again the best way to bring this home would be to provide an audited and objective analysis of the true cost – actual and opportunity cost – of historic performance. Yet few seem bothered to ask, let alone to make the effort to discover the answer to this relatively simple question.

As Bill Gross of Pimco pointed out over the summer, one of the many disquieting aspects of the current economic environment is that zero interest rates and massive Government intervention have hugely raised the opportunity cost for investors who carry on the way they have done in the past, while also serving to dampen what can be realistically be expected in the way of future returns when the unprecedented stimulus finally comes to an end.

The unspoken aim of Government policy now is to recapitalise the banks by leaving depositors with minimal returns from cash and short term Government bonds, and allowing the banks to make easy, privileged geared returns from their artificially low funding costs. The inevitable price to be paid for this in the short term (though it is a reward for those who understand what is going on) is asset price inflation. In the longer term the price will be the return of price inflation itself and almost certainly slower economic growth.

Written by Jonathan Davis

October 27, 2009 at 10:20 PM